Does M1 and M2 Contraction Signal Debt Deflation?

Ambrose Evans-Pritchard in “Monetarists warn of crunch across Atlantic economies” in the Telegraph points to a troubling development: a fall over last few months in M1 and M2 in the US, UK and EU.

Many have criticized the Fed for “printing money” of late. But the evidence suggests otherwise. First, all of the cash injections that the central bank has undertaken via its alphabet soup of new lending facilities have been met with roughly equal withdrawals though open market operations. Thus the new facilities themselves have not led to monetary expansion.

Second, critics like to point to the Fed’s negative real interest rates as lax monetary policy. In the dot-bomb environment, which was not a credit crisis, that charge is accurate, and that policy helped create our current mess.

But we now have credit contraction. Deleveraging is deflationary. Somewhat loose monetary policy is appropriate. Unlike 2002, banks or securities firms are not going out to create new debt, which is the mechanism by which low interest rates lead to inflation or asset bubbles. Mortgage lending has become dependent on the Federal government via Freddie, Fannie, and the FHA (and the future of that support is now in question). Consumer credit of all sorts is being reined in. Dow Chemical had to go to Warren Buffett to borrow to acquire Rohm & Haas because it could not get funding from banks. Our credit intermediation system is barely functioning.

And oil is now playing a role that is weirdly parallel to gold in 1931. England abandoned the gold standard, which was tantamount to a devaluation. The US stayed on it at that juncture and raised interest rates even though the economy was very fragile. Countries that stayed on the gold standard in 1931 on average suffered a 15% fall in real GDP in 1932.

But gold was not an essential economic input. Oil is, and thus constrains the Fed’s ability to lower rates further (not that it has much leeway at 2%, since most economists regard going below 1% as risking falling into the zero interest rate trap that has enmeshed Japan).

From the Telegraph:

The money supply data from the US, Britain, and now Europe, has begun to flash warning signals of a potential crunch. Monetarists are increasingly worried that the entire economic system of the North Atlantic could tip into debt deflation over the next two years if the authorities misjudge the risk.

The key measures of US cash, checking accounts, and time deposits – M1 and M2 – have been contracting in real terms for several months. A dramatic slowdown in Britain’s broader M4 aggregates is setting off alarm bells here.

Money data – a leading indicator – is telling a very different story from the daily headlines on inflation, now 4.1pc in the US, 3.7pc in Europe, and 3.3pc in Britain.

Paul Kasriel, chief economist at Northern Trust, says lending by US commercial banks contracted at an annual rate of 9.14pc in the 13 weeks to June 18, the most violent reversal since the data series began in 1973. M2 money fell at a rate of 0.37pc.

“The money supply is crumbling in the US. There was a very sharp lending contraction in the second quarter lending. If the Federal Reserve is forced to raise rates now to defend the dollar, it would be checkmate for the US economy,” he said.

Leigh Skene from Lombard Street Research said the lending conditions in the US were now the worst since the Great Depression. “Credit liquidation has begun,” he said.

The Fed’s awful predicament does indeed have echoes of the early 1930s when the bank felt constrained to tighten into the Slump in order to halt bullion loss under the Gold Standard. Investors – notably foreigners – dictated a perverse policy. Over 4,000 US banks collapsed. This time a de facto “Oil Standard” is boxing in Ben Bernanke. Benign neglect of the dollar has started to backfire. It is pushing up crude, with multiple leverage.

The monetary picture is highly complex. The different measures – M1, M2, M3, M4 – have all given false signals in the past. Each tells a different tale, and monetarists fight like alley cats among themselves.

The Federal Reserve stopped paying much attention to the data a long time ago. It has abolished M3 altogether. The US economic consensus is New-Keynesian (dynamic stochastic general equilibrium model). Delving into the money entrails is derided as little better than soothsaying.

That attitude, retort monetarists, is the root cause of the credit bubble. The money supply almost always gives advance warning of big economic shifts. Those who track the data are now calling on central banks to move with extreme caution. If the rate-setters overreact to an inflation spike caused by oil and food – or confuse today’s climate with the early 1970s – they may set off an ugly chain of events.

“The data is pretty worrying,” said Paul Ashworth, US economist at Capital Economics. “US lending is shrinking dramatically in real terms, and we know from the Fed’s survey that banks want to tighten further. People are clamouring for higher rates but we think deflation is now the biggest threat. The idea that the Fed should tighten with unemployment soaring is preposterous,” he said. The jobless rate jumped from 5pc to 5.5pc in May.

In Britain, the Shadow Monetary Policy Committee – hosted by the Institute for Economic Affairs, and a refuge for UK monetarists – issued its own alert this week. The focus is on “adjusted M4”, which covers loans to “private non-financial corporations” and may offer the best insight into the health of British business.

The growth rate has dropped from 16.1pc a year ago to minus 0.5pc in April. It is the suddenness of the decline that matters most. The data reeks of recession. Professor Patrick Minford from Cardiff Business School called for an immediate rate cut, arguing that the credit crunch is a more powerful and long-lasting force than the oil inflation.

Professor Tim Congdon from the London School of Economics said the UK was lurching from boom to bust. “Real money growth is virtually nil. The British economy is taking a thrashing and it is going to get worse. Corporate money balances have contracted 3pc over the last three months, which is double digits on an annualised basis. This is a serious squeeze for companies,” he said.

Mr Congdon warned three years ago that surging M4 would lead to a “dangerous” bubble, which is what occurred. He now fears the MPC will react too late as the process goes into reverse.

Roger Bootle from Capital Economics said Britain could be facing a “real economic crisis and a financial collapse. The MPC does not have the luxury of waiting until all is absolutely crystal clear. By that time the bird will have flown.”

The eurozone is at a later stage of the credit cycle. Even so, house prices are collapsing in Spain, and falling in Germany and France. German industrial orders have dropped for the last six months in a row. A joint IFO-INSEE survey said eurozone growth had stalled to zero in the second quarter.

“Consumer lending has fallen off a cliff. It is contracting in real terms,” said Hans Redeker, currency chief at BNP Paribas. Core inflation has fallen from 1.9pc to 1.7pc over the last year.

Unlike the Fed, the European Central Bank keeps a close eye on money data (though not on real M1, now shrinking). It looks at the broader M3 figures. There is a raging debate in Europe over the signals now being sent by this indicator.

The M3 growth is still 10.5pc, down from 11.5pc in January. However, the data has been badly distorted by the closure of the capital markets. Firms have been forced to draw down existing credit lines from banks, which shows up as M3 growth. (It is the same story with America’s M3 since the collapse of the Commercial Paper market).

“The credit lines are expiring. Companies cannot roll over loans. We are going to see the entire private credit multiplier go into a slowdown,” said Mr Redeker.

Jean-Claude Trichet, the ECB’s president, said last week that the M3 data “overstates the underlying pace of monetary expansion”. The ECB nevertheless pressed ahead with a rate rise to 4.25pc, setting off a storm of protest. This may go down as one of the most unwise monetary decisions of modern times.

The strain on eurozone banks is growing by the day. They bid a record $85bn (£43bn) at the ECB’s last auction for dollars. Only $25bn was available. The spreads on Euribor interbank lending are still at extreme stress levels.

Few disputes that “global inflation” is taking off. Over 50 countries now face double-digit price rises. Ukraine (29pc), Vietnam (27pc), and the Gulf states are out of control, with Russia (15pc), and India (11pc) close behind. China (7.1pc) is on the cusp. Interest rates are still below inflation across much of the emerging world. This is the driving force behind spiralling commodity prices.

The oil spike is already squeezing real wages in the Atlantic region. The debate is whether the Fed, Bank of England, and ECB should squeeze them further, trying to off-set energy rises with a deflationary bust in the rest of the economy. If and when oil peaks in this cycle, they may find inflation crashing faster than they dare to imagine.

The 9th Circle in Dante’s Inferno – starring Judas and Brutus – is a frozen lake. Cold can be more frightful than heat. “Blue pinch’d and shrined in ice the spirits stood,” (Canto XXXIII). Such awaits the victims of debt deflation.

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  1. Anonymous

    If an economy can’t handle 5% interest rates, then something is fundamentally wrong with the economy, and it deserves to collapse.

  2. Aaron Krowne

    Your comment that a super-low interest rate is a useful thing in a credit contraction is a non-sequitur. There is plenty of credit: banks just cannot extend it, because the default boogeyman may lie under any “asset”. No one can tell assets from liabilities! And they have a good reason to be afraid.

    This is the “pushing on a string” phenomenon, credit crisis version.

    The second problem is that the zero-risk interest rate governs where global capital will go. You admit that oil is rising probably as a direct consequence of this, in lieu of gold (which has been aggressively demonetized).

    Methinks economies will be hurting a lot more for facilitating oil as a safe haven than gold.

    I am left I wonder what your suggestion is.

    The article is also a non sequitur. Aren’t we *already* clearly in a debt deflation? *Potential* crunch? You’ve got to be kidding me.

    Debt deflation is here, but we’re *still* getting monetary inflation in the real economy — that is because of global dynamics. Plenty of “money” has been printed… 90% of it could disappear and if that last 10% sought safe haven in commodities, we would have hyperinflation. Global hyperinflation.

    I say we’re on the way.

  3. Citizen BagHolder

    “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate… Purge the rottenness out of the system.”

    – Not Hank Paulson

  4. JKH

    Nice to see some counterbalance to run of the mill inflation concerns.

    Since most money is in the form of bank liabilities, we now have a shortage of bank capital, bank credit, and bank deposits. The Fed doesn’t need to measure money supply with a microscope and categorize it ad nauseum to see what’s going on. This is part of the context for monetary policy risk. Obviously they have to be concerned about the risks of premature tightening.

  5. a

    “[ECB’s raise of 0.25%] may go down as one of the most unwise monetary decisions of modern times.”

    Um, well I think the up-again, down-again rate rises and falls of the Greenspan Fed will win hands down, over a 0.25% change.

  6. Yves Smith


    Interest rates are hardly “super low” if money supply is contracting. Indeed, what got us in this mess in the first place is the abandonment of money supply as a tool when in the early 1980s. Interest rates are a function not only of domestic policy but also import inflation and deflation. The power that be failed to factor the deflationary effects of cheap foreign goods into their policies in the 1990s and early 2000s; they are similarly not parsing the goods prices they can influence versus the ones determined by international forces. Policymakers tend to treat the US as a closed system.

    A better understanding of money supply might have prevented the costly error of protracted lax monetary policies.

    Financial innovation (minor by our standards, basically increased use of money market funds and interest bearing checking accounts) made the traditional Ms behave in ways not then understood starting around 1982. That might have argued for some experimentation and more important, study of what Ms and what factors along with Ms needed to be considered in formulating monetary policy.

    Presumably, velocity of money was changing. Fine, get a handle on that. But instead money supply was abandoned and a method with no experimental or theoretical foundation, inflation targeting, has been adopted formally by the EU (and in the US, informally). I’d be happier if they used astrology.

    Back to the post. No, I did not make a suggestion here. Does every blog post require a policy recommendation? Tell me how often you see them at Calculated Risk or The Big Picture.

    The implication of what E-P says is a rate rise would be disastrous. I have not gone that far, but I have said several times in other posts that the Fed would be best served to do nothing for a few months and wait until more data comes in. I suspect we will see stronger evidence of deflation by then (for instance, Gary Shilling is calling for a big drop in retail sales despite rising food and gas costs).

    I have also said repeatedly that the reality is that Fed will not raise rates. They will get too much evidence of weakness in the banking system plenty soon (that has arrived on cue), and they have been very attentive to the needs of bankers.

    I never suggested that lowering rates would be a remedy in this situation. However, I have had the view that the risks of deflation have been underestimated. Most people are not willing to consider how diseased the banking system is. It seems inconceivable to most that a seemingly modern economy can go into a banana republic financial crisis. So that scenario is dismissed or treated as the province of alarmists.

    Yet every day, the patterns look increasingly reminscent of the Great Depression and the Asian debt crisis. Raising interest rates in those conditions lead you straight to wide scale business failures and massive job losses.

    Liquidiationists should be careful what you wish for.

  7. Anonymous

    well said Y…to offer a very simple local example. I have been considering purchasing a home in southern ca since january. I finally found a fixer that is not listed that I believe is a good deal. only problem is the loan I qualified for just 6 weeks ago is “no longer available”. honestly I don’t blame the lendor…I was surprised they “took” me to begin with. not that I am a high risk just that I started with a new company in jan (increased position, 7 yrs with former company). long story short I could have purchased the house 6 wks ago and now I can’t. I have to believe this situation is repeating across the US.

    sorry for spelling and caps…on a phone.

  8. Doc Holiday

    Re: “Benign neglect of the dollar has started to backfire. “

    This neglect is reenforced by the stupidity of Paulson, et al and the continued theoretical rhetoric of talking about a strong dollar, but then allowing it to plunge, month after month in a cascade of doubt! These political puppets are parading around in circles in dance steps which have become an incoherent puzzle seemingly engineered by a supercomputer run by retards. These puppets reinforce the notion that God does play dice with the universe and he is currently using a bastard like Paulson as his tool to prove a point about evil and thus make humanity suffer for decades…. (it gets worse)!

    “Financial turmoil is ongoing” so more U.S. regulation of securities firms is needed, Fed Chairman Ben S. Bernanke said in testimony before the House Financial Services Committee yesterday. Paulson reiterated a desire for a “strong dollar,” saying the currency should reflect the U.S. economy’s “long- term” fundamentals.

    The dollar has fallen 11 percent against the euro since Sept. 18, when the Fed made the first of seven reductions in its target rate for overnight lending between banks to help avert a recession. The Dollar Index traded on ICE futures in New York, which tracks the greenback against the currencies of six U.S. trading partners, fell as low as 72.368, the lowest level since July 2.

  9. Michael McKinlay

    The problem is fractional reserve banking which in reality is leveraged debt banking

    The privately owned and operated Federal Reserve should be replaced with a public institution that produces money without debt. Leveraged debt is the problem of the private bank’s monopoly on money creation.

    With a public central bank that produces money and credit without debt the government , we the people garner the profit from creating money, not the banks. With a public central bank credit can be allocated through interest rate differentials to sustainable uses rather than auctioned for consumption. With a public central bank interest rates can float rather than be manipulated for political or profit motives.

    Our right to create money, granted by the Constitution has been usurped by the banks for printing their own interest bearing money that they lend at leverage. The prerogative and benefit of money creation is the property of the government and its citizens.

  10. a

    Another comment if I may.

    If the scenario is inflation now and deflation later, then it would seem that the proper interest-rate course is to have higher rates now, while there is inflation, and to lower them only once deflation sets in. The ECB, by getting in an interest-rate increase now, has more ammunition than the Fed, which has pretty much squandered its ammunition while the enemy was miles from the gate.

    That is, it seems to me that the “Deflation is coming” doomsters’ desire to lower interest rates *now* will only increase inflation now, and thus will only increase deflation later. Suppose, for the sake of argument, that wages stay constant at 1 and the “natural” price of widgets is also 1. Because of easy credit, prices of widgets have increased from 1 to 1.5 and are increasing rapidly. And suppose it can be foreseen that the price of widgets will begin to decrease in six months. It seems to me that it is the wrong policy reaction to try to arrest deflation now, when there is none, since that will only inflate *more*, and send the price of widgets to 1.7 or 2, in which case the feared deflation will be even worse once it sets in, and the widget price reverts to 1.

  11. Dan

    Bravo. Monetary deflation is what is happening in the US. It is amazing that the central bank of the most powerful country in the world is guessing where to set interest rates. Since this is the case, one might ask: “What is the purpose of the federal reserve?” Considering the feds policies are partially(if not mainly) responsible for the mess we are in, and considering that they(the Fed) are attempting a power grab to control more than our rule of law allows(even though it doesn’t allow a central bank at all), one might conclude that a central bank is decremental to a functioning society. (note: a central bank is key to a socialist/communist and/or fascist state.)

  12. Yves Smith


    With all due respect, please read up on the effect that interest rate increases in 1931 in the US and in Thailand and Indonesia in their debt crises had. The way interest rates kill inflation is by slowing economic activity. That is already happening, big time.

    As other readers have pointed out (most notably Independent Accountant), the sudden increase in oil prices is having an effect just like Smoot Hawley.

    Rate increases in the US simply won’t happen in any event. The Fed won’t take that chance with banks as wobbly as they are, particularly now the Freddie/Fannie/IndyMac tsuris.

    Your energy would be better spent trying to get Congress not to put through another stimulus package, which is in the cards before the fall recess. That is far worse, as far as inflation is concerned, than sitting pat on rates when no one is lending anyhow.

  13. poszi

    I find it very interesting that for even such a fundamental economic problem as whether there is deflation or inflation (monetary or whatever), there is a heated debate among economists. It doesn’t particularly give confidence to the economics.

    I understand the inflation/deflation problem as that we have had a huge oversupply of money until 2007 and now it appears there is a short-term contraction. I believe fighting this contraction is inflationary because the money supply increases are cumulative. The money overhang from the previous years has not yet fed totally into the system. Moreover, the developing countries have not experienced the contraction, yet. The CPI increases are a result of combination of the past inflationary policies, current inflationary situation in the developing countries, and to some extend the commodities markets fear that the central banks will be irresponsible and would monetize the bad debts.

    Judging by the “it will not happen” Bernanke speech, I seriously doubt, deflation will happen. Fed would inflate any serious money contraction.

  14. Anonymous

    Your energy would be better spent trying to get Congress not to put through another stimulus package, which is in the cards before the fall recess. That is far worse, as far as inflation is concerned, than sitting pat on rates when no one is lending anyhow


    Is this not the danger that could cause a continuation of inflation? If the world economy meaningfully slows and foreign central banks no longer buy our debt in bulk, will the U.S. Fed need to purchase obligations of the treasury and GSEs? (foreign central banks are doing this for us now and suffering inflation because of it). Wouldn’t this be the true danger that inflationists fear? Doesn’t owning the printing press for the world’s reserve currency allow congress and the Fed to initiate an out of control inflation in non-paper assets? (the government underwrites the bond market while speculators move to hard assets). Are we not in a classic inflation yet, but set up for one soon? The response to Fannie and Freddie do not encourage my deflationist worries.

    Asking because I fear but do not presume to know.

    Thanks for your wonderful blog,

  15. Anonymous

    I’m in the stagflation camp. You cut back on things you don’t need to buy things you do need. Wait until you can’t afford either one.

    Factional reserve banking is bad enough but don’t forget about ‘compound interest’

    Deflation my ass, liquidation brings about deflation and causes a stronger currency. The Government has done nothing but transfer debt around. They are about to do it again with this latest bank failure. We will get deflation but a large dose of inflation comes first as the tax base erodes and funding becomes internal when the world cuts the support lifelines.

    A see another rate cut next month to assist the banks that are to big to fail.

  16. Yves Smith


    I need to turn in, and this is very off the cuff. I think it depends on what consumers do.

    Japan first tightened too much, failed to recapitalize its banks, cut rates to zero and engaged in massive fiscal stimulus. They got deflation. People were saving out of distrust of the financial system and lack of social safety nets.

    So it really depends in very large degree on consumer/business response. If you see a lot of anticipatory spending (ie, people spending their earnings as soon as they get them because if they wait, whatever they buy will cost more), the propensity to spend keeps inflation going. I behaved precisely that way as a college student in the 1970s. I had to plan, but I spent my allowance (which I got annually) and summer earnings ASAP except for a wee bit for discretionary spending. It went further that way.

    Similarly, deflation feeds on itself. If people save (or pay down debt, that too is a form of saving), that is deflationary. And since the economy is lousy and people aren’t out spending, the peer pressure to spend is less. Savings and parsimony become fashionable.

    And Americans who have suddenly realized they can’t depend on their friendly debt merchants are going to be building up savings, or at least reducing debt, which is a reversal of the pattern of the last 15 years.

    And the reason I am reasonably confident of the “savings go up” thesis is that our savings rate is unsustainably low, and by a big margin. Merely getting it to a barely sustainable level means either a very very bad recession or quite a few years of subpar growth.

  17. Yves Smith

    I would also not take much comfort from our reserve currency status. The US had to issue “Carter bonds” DM denominated bonds, in the 1970s. We have a very big increase in Treasury issuance in progress and not stopping any time soon thank to Iraq. There have been some weak 10 year Treasury auctions.

    So the odds are good that in the case of aggressive fiscal stimulus, either domestic long bond rates go through the roof, which will kill the economy (no one invests when interest rates are high, projects simply don’t work with high DCFs) or we fund in foreign currencies, which similarly makes us very careful about not debasing the currency (contrary to recent carry trade wisdom, inflation beyond a certain point is very bad for currencies. India and Vietnam are now having to defend their currencies. Remember the peso crisis?)

  18. a

    “With all due respect, please read up on the effect that interest rate increases in 1931 in the US and in Thailand and Indonesia in their debt crises had.”

    So you think the 1930s Depression was caused by interest rate increases? Really? It’s all the Fed’s fault? Had nothing to do with a run-up of debt in the 1920s or rampant greed on Wall Street (i.e. too much of the national wealth being siphoned off by non-productive elements of the economy)?

    “The way [increases in] interest rates kill inflation is by slowing economic activity.”

    And interest rate decreases increase economic activity? Doesn’t seem to be working so well in the U.S. Rates more than halved, largely into negative real territory, and the U.S. economy still heading into a Depression.

    “That is already happening, big time.”

    What is happening big time? Slowing economic activity in the U.S.? Sure (and note Fed interest rates are down). Inflation in commodities is going up, which is bringing up inflation everywhere. Sure, eventually that slowing economic activity will cause inflation to drop, but by letting inflation go up even more now, deflation – if that is what we are to get – will be even more severe when it sets in.

  19. Anonymous

    For all intents and purposes we’re experiencing a liquity trap. Balances sheets are contracting, the ‘left’ side faster than the ‘right’ side. Years of growing leverage has killed the capacity to lend.
    Lags: money is the not the issues, lending is. Print money it’ll languish, but globally consumption does not have a short term substitute. However markets clear, prices are a reflection of global considerations. There are no giffen goods for oil in the short run. Higher prices will eventually result in shifts of supply and demand curves, substitutions aside.
    The issues will resolve, but structurally you have political hacks in the spotlight with limited resolve and intelligence obstructing a timely, but painful resolution.
    This is a socialist economy corrupt and inefficiently allocating resources with the resultant outcome extended by disruptions caused by a combination of reactive short term rather than long term proactive solutions.
    The impact will lag for years.

  20. RebelEconomist

    What makes me sceptical about this talk of depression is that I have heard it before – at the time of the 1987 crash, 1998 LTCM crisis, Y2K, 9/11 etc etc. Each time, the example of the 1930s depression gets wheeled out, despite the fact that there were more factors contributing to that than monetary policy (eg short term mortgages that were not rolled over even when performing, tariff barriers, small and rigidly balanced public sector budgets, business-handicapping legislation etc) which would be unlikely to apply today. It is not even clear that inflation has stopped rising yet. Until it does, the Fed should err on the restrictive side. They have cried “Wolf!” too many times.

  21. Fullcarry

    I have been hearing about predictions of deflation since the late 60s also. And yet we haven’t had even one year where prices declined.

    Deflation is an alluring fixation for many. But the chance that the purchasing power of the Dollar is going to start increasing systemically seems to me to be nill.

  22. Yves Smith

    I did not worry about deflation in 1987 and having lived through the crash and having well placed buddies in policy circles in Japan at the time (the Fed called the BOJ to have Japanese banks buy Treasuries big time early in the week after the crash, a fact not widely known here), I do not recall any discussion of deflation then.

    I was not worried about deflation in 1990, when S&Ls were falling over right and left (S&Ls were only a part of the financial system. However, the rest of the banking system was undercapitlaized, and the remedy was a steep yield curve to allow banks to rebuild their balance sheets. This is one thing Greenspan did correctly and is not given credit for it). I was not worried about deflation as a result of the LTCM bailout or in the dot-bomb era (that concern seemed very peculiar then. The banking system had very little exposure to that equity bubble). I imagine by extension that there are others who are worried about deflation now who were not in these past financial upheavals.

    There has been a massive, unsupportable increase in debt to GDP in the US from 2002 to today. Debt to GDP is higher than any time in US history, including prior to the 1929 crash. This is a completely different fact pattern than what we have had previously.

    There isn’t a class of financial intermediary unscathed and we aren’t even very far into this process. Every major investment bank save Goldman is affected (and I expect their good luck to run out at some point). Every major and most middle to small commercial banks in the US are affected. Even some insurers and non-bank players are taking hits, witness AIG.

    Similarly, past financial crises did not have repeated, visible interventions that failed to do the trick. The TAF in December and the other Fed facilities of March are simply unprecedented, We also have the covert bailouts vis heavy use of the Federal Home Loan banks. We have a partial nationalization of the banking system already, yet CDS spreads and the TED spread have started again to move in the wrong direction. This is not even remotely like what we saw in 1987, 1998, or the dot bomb era.

    We are having runs on banks. Bear. IndyMac, Lehman on the edge. The Fannie/Freddie soap opera is very bad for psychology. Small banks are probably next to start hitting the wall.

    A lot of the excess debt created will (is) going bad. That in turn will (is) going to destroy or impair a lot of financial institutions. If you have a crippled banking system, stimulus does not work, witness Japan.

    You need to read Carmen Reinhart’s and Kenneth Rogoff’s research of postwar housing bubble collapses plus their work on financial crises. High international financial liquidity is associated with international financial crises.

    And I never said that the crisis was caused by raising interest rates, which the Fed has not done of late. But raising rates when the financial system is about to fall over will turn a bad recession into something worse.

    And as I have said repeatedly, this discussion is academic. The Fed is not going to raise rates (well, there is one extreme scenario. if in a parallel to Thailand, we have a run on the dollar. But all that would do is worsen the domestic economic situation and merely forestall the inevitable a very short time. Since the US has inadequate FX reserves to fight a sharp dollar decline, coordinated intervention is far more likely. And believe me, if oil prices ease, Bernanke will cut the dollar loose).

    Note I have not advocated cutting rates and said many many times the Fed cut too deep too fast. I doubt the Fed could do as much as some would like to believe to contain this crisis, but it now has pretty much no options.

    You can have deflation and a currency crisis in combination. I have said repeatedly that our situation is very much like that of Indonesia and Thailand circa 1997, except we have the reserve currency and nukes. But having the reserve currency did not stop England from abandoning the gold standard in 1931 (in effect, a large devaluation).

    As I have said before, I strongly recommend reading up on the Asian financial crisis. I have noted before that when their currencies collapsed, they got two hits: considerably higher import prices (in their case, food price increases led in cases to riots) and vastly higher debt service costs, since they had a lot of foreign currency denominated debt, which led to even more business failures. We would not have the latter in case of a fall in the dollar, but until demand destruction goes further, we’d have a nasty increase in oil prices.

    In fact, the real lesson of the 1997 crisis is that there is probably no way out of this mess that does not involve substantial pain. You can have the shock treatment of a sharp fall in GDP, falls in asset prices, major unemployment and political instability, or you can try to go the Japan route of paying the piper over many years.

    Remember, as Brad Setser has pointed our repeatedly, our foreign capital inflows are entirely dependent on foreign central banks. Foreign private investors know better.

    And even though optimists like to comfort themselves by saying that the central banks won’t let the dollar fall and take FX losses, they already have.

    Remember Herbert Stein’s dictum: that which cannot be sustained will not be sustained.

  23. Anonymous


    You are confusing me. Most of your arguments only prove that inflation is inevitable.

  24. Yves Smith

    I might add that the allusion to deflation risk by the Fed may in fact be cover for the fact that they have come to see that banks are in a solvency crisis.

    How do you deal with a solvency problem? By reducing the value of the debt to what the debtor can repay (assuming the debtor is worth more alive than dead). What is one way to reduce the value of debt? Inflation. So if oil and food prices were not a complicating factor, you’d see the Fed going for the same result, regardless of its reasoning.

    Having said that, the financial system is in very bad shape and money supply contraction does suggest a real risk of deflation.

    Even though I have been comparing the US to a banana republic for some time (in terms of its true financial condition, as well as its willingness to publish dubious financial statistics to mask the extent of the rot), I have also recognized that in the past we have managed to bumble through and avoid worst-case outcomes due to a combination of luck and corrective action. I have thus discounted my own forecasts.

    Yet as the crisis rolls along, thing are turning out every bit as badly as I feared. And per the banana republic image, we probably have an air-brushed picture of what is really going on.

  25. Yves Smith

    Anon of 6:49 PM,

    Budget deficits do not always result in stimulus or inflation. Japan in the early 1990s ran massive budget deficits to fund domestic infrastructure projects and still got deflation.

    And our current budget deficits are going in some measure to fund the Iraq war. I have seen stats that say that much of those costs are not benefiting the US economy but are going into Iraq (for instance, payments to all those subcontractors to Halliburton). I cannot recall where I saw the figures, sadly. But here you have spending which is not stimulating the US economy.

    Similarly, in 1930, the Fed tried increasing money supply to stave off an economic collapse. It increased the monetary base, which is what it controls. But money supply contracted anyhow because people pulled cash out of banks.

    If you have a seriously impaired financial system, the normal mechanisms to transmit stimulus (which leads to inflation as well as economic growth) can work in a diminished fashion or not at all.

    For instance, the powers that be lower interest rates but banks don’t lend, or lend very little. Lowering interest rates is supposed to be stimulative because it should encourage banks to borrow more to then lend to customers who spend or invest (similarly, the banks should be able to offer more favorable rates than before, which will induce some borrowers to proceed when they might have held back with higher rates). But if banks won’t lend because they have too many dud loans and are too freaked out to take risks, the transmission mechanism is impaired.

    Worse, in this case, central banks are demanding that they increase their capital bases. I can see that as an objective over the next three years, say, that’s imperative. But to demand that now REQUIRES them not to extend new loans. They have to shrink their balance sheets to conform with the new capital targets.

    We did get inflation in the 1930s AFTER the banking system collapsed, AFTER the securities laws were implemented, and AFTER the FDIC was created. The Fed in 1933 abandoned the gold standard and in 1934 successfully tried to reflate.

    Inflation after a period of deflation is considered to be an good thing (provided worker wages rise along with prices). The rise in inflation in the 1930s was seen as a sign that the economy was on the mend.

  26. Anonymous

    “Remember, as Brad Setser has pointed our repeatedly, our foreign capital inflows are entirely dependent on foreign central banks. Foreign private investors know better.

    And even though optimists like to comfort themselves by saying that the central banks won’t let the dollar fall and take FX losses, they already have.

    Remember Herbert Stein’s dictum: that which cannot be sustained will not be sustained.”

    This is simply not an argument for deflation in the US. Foreign dollar peggers are keeping the dollar more expensive than it would be otherwise.

    Also in your subsequent post you start comparing things to the 1930s. But there are huge differences between now and then not least that the dollar was tied to Gold and the central bank back then was much more restrained in what it could do.

    We have already seen that the current FED can and will do what it takes to save the financial system. And even if somehow the year over year supply of dollars should decline for a short period of time I can assure you in the current environment the demand for dollars is going down far faster.

  27. RebelEconomist


    While you did not explicitly say that you were addressing my comment about the Fed crying wolf, note that I said that “depression” not “deflation” was used to justify easing in 1987. And I must say, I am surprised to read that you approve of Greenspan’s response to the thrifts crisis. As you say, he engineered a slealth recapitalisation at the expense of holders of interest-bearing debt and thereby avoided the kind of overt, accountable workout that might incentivised governments to resist the development of future too-big-to-fail activities.

    I am sure that you are right that the latest crisis is the worst of those mentioned, but how do we know that, if this crisis is successfully forestalled, it does not lead to an even bigger one? Have a quick look at my blog posting at where I present evidence of how these previous bailouts conditioned investor expectations. No doubt some kind of mitigating policy action is needed in the present crisis, but it is important that it does not prevent an adjustment to more sustainable expectations.

  28. Yves Smith

    Rebel Economist,

    As I said, I was around during the Crash and I do not recall people being worried about a depression. There is a big difference between saying “this is the biggest stock market fall since the 1929 crash” and “this is going to produce a depression.” Indeed, equity prices had substantially recovered in a mere three months. That is confirmed by the fact that the Fed did not start a rate cutting cycle in response to the 1987 crash. They did not commence until July 1990.

    The banking industry was far less concentrated in 1990 than it is today. The problem at the end of that recession was not a banks to big to fail (Citi was alone among big banks in having very large exposure to Texas real estate. It had done a number of junior debt deals to what turned out to be see through buildings). The issue was not that the banks that should have failed were kept from failing. That’s why the Resolution Trust Corporation was formed, to deal with the many banks that WERE taken over by the FDIC.

    There is no statutory authority to shut down a bank that is somewhat low on capital but in no danger of failure. There were quite a few middling to small banks in that category in 1991. The regulators can tell them to get their ratios up. That means not lending so balance sheet runoff takes care of the problem.

    Moreover, there is no evidence that the steep yield curve of the 1991-1993 period did long term damage. We did not get an asset bubble or other bad outcomes. It was later cycles, the 1995 cycle, the 1998 cycle, and the 2001 cycle (and keeping rates too low thereafter) that look to be the culprits for our current mess.

  29. RebelEconomist


    I was around in 1987 too, but don’t take my word for it. It is not necessary to look any further than the Wikipedia entry for “stock market crash”, which says of the event: “Despite fears of a repeat of the 1930s depression, the market rallied…”. The front page of the New York Times for October 20th 1987 makes several references to the depression following the 1929 crash. I do not know what qualifies as a “rate cutting cycle” but the Fed cut the Fed funds target rate on November 3rd for reasons discussed by Hafer and Haslag in the St Louis Fed Review of March/April 1988.

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